Warren Buffett once stated that “Interest rates are to asset prices what gravity is to matter”, from this you can hopefully start to see why investors would care about global interest rates. So what exactly do I hope to accomplish through writing this post you may ask? Well, if we go back to Mr Buffett’s example, what do you think would happen if that gravity was exerting near zero pressure on some form of matter for almost 9 consecutive years? Exactly, that same piece of matter would now most likely have become so distorted that it would be unrecognisable, and no amount of gravity could, in the short term at least ever return it to its original state. My hope is that through this short post, hopefully the wider public is able to at the very least have a brief idea about why our central bankers (in attempting to save us) may have actually doomed us.
How and why exactly do interest rates affect the financial markets?
This seems like a pretty logical place to start. Well what you may or may not be aware of is that investors, whether it be little old grandma Jo with her few thousands in retirement savings or Billionaire’s like Kjeld Kirk Kristiansen (look him up) are all looking for ways that their money can make them more money. Pretty simple right? Well, kinda. You see grandma Jo like KKK has various ways she can go about doing just that, she could open up a brokerage account and slap that principle into an index fund (If she was smart she’d have done that in her late teens/early 20’s but that’s another story ), she could also try her hand at trading the markets (Don’t.) she could also invest in a local business, but there is a much easier way she could go about getting that sweet yield she craves. Just drop it into a bank account and collect interest on it. Simple. Now here’s where it gets interesting okay. From that brief example I’ve essentially outlined what the relationship between interest rates and financial markets is. Its all down to opportunity cost, if just leaving money in your bank account can get you a 10-11% rate of return (forget inflation for now) with next to no risk to capital, why on earth would grandma Jo want to buy one of those fancy Vanguard index funds or trade the markets herself (Seriously. Don’t.)? Exactly. She wouldn’t. Grandma Jo is like the vast vast majority of investors out there (risk averse) and herein lies the problem.
The Problem (INTRO)
Lets say bank accounts don’t yield a 10-11% return, lets say they don’t even yield a 2-3% return (less than expected inflation). Now what? Well forgetting grandma for a second, almost every investor in the modern world will either invest their money into local business’, hard assets such as gold and land or the financial markets. This is why you almost always see asset prices rise across the board as interest rates fall. This is usually a good thing right? Consumer confidence grow as a result of the wealth effect/increased investment into business’, people see themselves being more well off through their houses and other investments increasing in value (Wealth effect again I know), overall there’s just more sunshine and rainbows all around. However, like all good things it must come to an end. The CB’s eventually raise rates, the markets (through movement away from riskier assets such as stocks etc) crumble back into correction territory, house prices fall, people lose jobs bla bla bla you know the deal. No matter how bad it is we always have to go through it guys. Its a constant cycle of boom and bust.
Until now that is. Central banks for almost a decade have kept rates at record lows and judging by recent events (Brexit, low oil, failure of QE to spur growth) show no signs of hiking them at all.
Firstly, you have the development of asset bubbles (yes they are bubbles), these usually aren’t too much of a big deal (other than if you’re caught in one thats bursting) but these current bubbles aren’t your ordinary hubba bubba bubbles that might leave you slightly sticky when they burst, these are bubbles made of molten steel pumped full of Zyklon B (scary huh) that will cause major major damage to not just you but to everyone around you. What I really mean is that you should take the molten steel to represent the effects of quantitative easing on equity markets and the Zyklon B to be the cheaply borrowed money that investors are ploughing into the financial markets to amplify their returns (leverage). When this bubble pops (and it will pop) it will cause so much damage not only to the billionaire hedge fund managers who run 100-1 levered funds but also (most importantly) to the average Joe Schmo who saw his neighbours with a new car they bought using the money from their “smart investments” and decided to remortgage his mums house to get in on the action.
The availability of cheap money to a public gripped by the hysteria generated by a bull market is like pouring kerosene on an already roaring flame…people get burned. This cheap money argument leads me nicely onto my next problem… capital efficiency.
In economic theory, interest rates serve to distribute capital (money) to those who need it to invest in the most economically productive projects. Basically, if you have an investment project that will increase productivity or provide an economically useful return, then the interest rate serves as a disincentive to those competing with you whose projects may not have such a good rate of return.
e.g. if you have interest rates at 4% and Company A wants to invest in a new factory that will generate a return of 3% while Company B wants to buy new machinery that will generate a return of 6%, because interest rates are at 4% Company A will not invest because it is not an efficient use of capital (it will cost them money), while Company B will. When interest rates are LOW (0-1% etc) , no one cares about using capital efficiently and you get poor economic decisions being made. How do you value something when its price is disconnected from rational economic decisions? This in my opinion is the biggest problem we are facing in the long term because when rates do (hopefully) rise, all these projects that are not viable economically will crash and burn, taking with them hundreds if not thousands of jobs.
I could go on to describe how other bubbles such as whole the buy to let fiasco will also suffer if rates continue to crater but that would really drag this article on. Even though this may not be the most eloquent post ever written on, I do hope you’ve learned something. If you still want to read more into the various issues I’ve brought up id highly recommend this article by Josh Brown (http://thereformedbroker.com/2016/02/25/abundance/).